As is so often the case with rapid financial sector liberalization, the government=s
capacity to regulate and supervise these transactions did not keep pace. At the same time, the
banking system was unable to allocate the greatly increased flows on an efficient basis. Bank loan
5
quality began to deteriorate, though not catastrophically. Some banks were undercapitalized,
non-performing loans were rising gradually, and many basic prudential regulations (such as
lending to affiliated companies) were regularly broken, with little penalty. There is little doubt
that these weaknesses in the financial sector were a key precondition of the crisis. These problems
were especially severe in Thailand. But were these problems, in and of themselves, severe enough
to warrant a crisis of the magnitude that actually took place in so many countries? Our view is
negative.